Reading 23 LOS's

Question 1

LOS 23 a: Explain the realtionship of financial statement elements and accounts, and classify accounts into the financial statement elements.

Answer 1

Assets are a company’s economic resources and they inclu_de:_

Current assets:

• Cash and cash equivalents
• Accounts receivable, trade receivables
• Prepaid expenses
• Inventory

Noncurrent assets:

• Property, plant, and equipment
• investment property
• intangible assets (patents, trademarks, licenses, copyrights, and goodwill)
• financial assets, trading securities, and investment securities
• investments accounted for by the equity method

Liabilities are creditor’s claims on a company’s economic resources:

• Accounts payable and trade payables
• financial liabilities such as notes payable
• deferred tax liabilities
• long-term debt
• unearned revenue

Owners Equity represents owners’ residual claim on a company’s resources

• Capital in the form of common and preferred stock
• additional paid-in capital
• retained earnings
• other comprehensive income

Revenues represent the flow of economic resources into the company:

• Sales
• gains
• investment income

Expenses represent the flow of economic resources out of the company:

• Cost of goods sold (COGS)
• Selling, general, and administrative expenses
• Depreciation and amortization expenses
• interest expense
• tax expense
• losses

Question 2

LOS 23b: Explain the accounting equation in its basic and expanded forms

Answer 2

The basic accounting equation is:

Assets = Liabilites + Owners equity

Owner’s equity is the residual claim of the owner’s on a company’s assets after all liabilities have been paid off:

Owners equity = Assets - Liabilities

Which can be further divided into two components:

Owners’ equity = Contributed capital + Ending retained earnings

Ending retained earnings are calculated as:

Ending RE = Beginning RE + Revnue - Expenses - Dividends declared

Therefore the basic accounting equation can be expanded into 2 forms:

Assets = Liabilities + Contributed Capital + Ending Retained Earnings

and:

Assets = Liabilites + Contributed Capital + Beginning Retained Earnings + Revenue - Expenses - Dividends declared

Question 3

LOS 23c: Explain the process of recording business transactions using an accounting system based on the accounting equation

Answer 3

The process of recording business transactions is based on double-entry accounting. If an asset account increases, either a liability or an equity/capital account will also increase, or another asset account will decrease to keep the accounting equation in balance.

Question 4

LOS 23e: Explain the relationships among the income statement, balance sheet, statement of cash flows, and statement of owner’s equity

Answer 4

Net income reported on the Income statement is relfected on the balance sheet under owner’s quity and on the statement of shareholders equity as net income.

The cash flow statement will show how much cash increases over a period, which is also reflected in the balance sheet

The owner’s capital contribution is shown on the cash flow statement as well as on the balance sheet under owner’s equity

Question 5

LOS 23d: Describe the need for accruals and other adjustments in preparing financial statements

Answer 5

Accrual accounting is based on the principle that revneues should be recognized when earned and expenses recognized when incurred, regardless of when the actual exchange of cash occurs. There are 4 types of accrual entries:

1. Unearned (or deferred) revenue- arises when a company receives a cash payment before it provides a good or a service to the customer. Because the company still has to provide the good/service, unearned revenue is recognized as a liability. Unearned revenue turns into revenue as it is earned
2. Unbilled or accrued revenue- arises when a company provides a good/service before receiving the cash payment. Because the company is owed money, accrued revenue is recognized as an asset. As they receive payment, cash will go up as accrued revenue goes down
3. Prepaid Expense arise when a company makes a cash payment before recognizing the expense. Expenses that have been paid in advance are an asset to the company. So cash would go down and prepaid expense would go up. Then as the expense is recognized, the prepaid expense would go down along with owner’s equity
4. Accrued expenses arise when a company recognizes an expense in its book before making a payment for it. Because the company owes, it is a liability. We see liablities go up as owner’s equity goes down. Then as we pay it we see assets go down, as liabliites go down

Question 6

LOS 23f: Describe the flow of information in an accounting system

Answer 6

• Journal Entries- the amount and relevant accounts affected by transactions are chronologically recorded in journals. At the end of the period, adjusting entries are made to journal entries to account for accruals that had not been recorded
• General Ledger - sorts all the entries posted in journals into accounts.
• Trial Balance- an initial trial balance lists all the ending balances of general ledger accounts. Adjustments to record accruals and prepayments that had not been considered in constructing the initial trial balance are made in the adjusted trial balance.
• Financial Statements the account balances in the adjusted trial balance are used to construct financial statements

Question 7

LOS 23g: Describe the use of the results of the accounting process in security analysis

Answer 7

Financial statements provide the basis for equity and credit analysis. However analysts must make adjustments to reflect the effects of items not reported in the statements. Analysts must also evaluate mamagement’s assumptions regarding accruals and valuations. It must be notes that these assumptions are in the hands of management, and they have the ability to manipulate and misrepresent a company’s true financial performance. Therefore while the accounting process is a start for equity and credit analysis, its must be taken with caution.